Unit level economics matter. They matter a lot. If you don’t know what they are, please take a look at this article I found via a quick google search. Toby Clarence-Smith, the author, does a fantastic job of describing the concept. I won’t go into detail about what unit level economics are or how to calculate them – I will assume you know that (or just read the article above). However, I want to discuss why they matter and how to apply them in strategic analysis.
But why should you care? Your Revenue is increasing and so is your bottom line! Let’s take a look at the most obfuscated case – when things go well. When everything is improving, the morale is high, you give random high-fives in the hallway (or am I the only one that does that?) and in general nothing can go wrong. Except that it can – and when things are going well, many of the red flags are overlooked or swept under the rug.
Let’s examine a use case. Let’s pretend we are running a delicious Ice Cream Shop: IceCreamCo. We start off selling Vanilla ice cream and sales are booming! The ice cream costs us $2 to make but we sell it for $5 per unit. We make $3 and a whopping 60% contribution margin (CM).
Let’s expand – we’re killing it! We add Chocolate and Cookies and Cream and get even more customers into our store. Nominally we’re getting more revenue and more profit. BUT let’s dig into the numbers.
The additional flavors actually have worse unit economics than vanilla. In fact, each additional flavor’s CM is falling.
Some of you might say, “Yeah, yeah – so what? This is to be expected. Its diminishing returns and as long as your sales and profits are growing keep at it.”
That’s true – while things are going well. But what if the market dynamics change? What if our Vanilla ice cream falls out of favor with customers. In fact, the Vanilla people stop coming to IceCreamCo. Well then the business not only sees a revenue and profit loss in nominal terms, it also has to expect and plan for a restructuring of the business dynamics. Remember, we have not even considered G&A and other overhead costs a business faces. The Product Mix changes and thus the corresponding unit economics changes affect how IceCreamCo. should:
• Be valued
• Manage its liquidity and cash projections
• Project its future sales
• Plan for inventory
• Evaluate its product mix – maybe we need to find a different, lower cost product to substitute for Vanilla
• Manage the organizational structure (maybe we will need more IceCream magicians to create new flavors)
• Evaluate procurement and sourcing (maybe vanilla was a super tough ingredient to source)
• And more
This is a simple example – but it is easy to see how understanding your business at the basic, unit level is paramount. In fact, if you don’t have a good view of your unit economics or your “SKUs” you should highly consider stopping or pausing “the presses” and getting a solid understanding of exactly how the sausage is made. (Have I managed to use all of the cliché metaphors yet?)
A good executive and/or CFO should be obsessing over unit economics and well as their cash position (for another blog post).